Earnings Quality and Stock Returns

Konan Chan, Louis K. C. Chan, Narasimhan Jegadeesh and Josef Lakonishok
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Konan Chan: University of Hong Kong and National Taiwan University
Louis K. C. Chan: University of Illinois at Urbana-Champaign and Hong Kong University of Science and Technology
Narasimhan Jegadeesh: Emory University
Josef Lakonishok: University of Illinois at Urbana-Champaign and National Bureau of Economic Research

Journal of Business, 2006, vol. 79, issue 3, pages 1041-1082

Abstract: An exclusive focus on bottom-line income misses important information contained in accruals (the difference between accounting earnings and cash flow) about the quality of earnings. Earnings increases that are accompanied by high accruals, suggesting low-quality earnings, are associated with poor future returns. We explore various hypotheses—earnings manipulation, extrapolative biases about future growth, and underreaction to changes in business conditions—to explain accruals' predictive power. Checks for robustness using within-industry comparisons and data on U.K. stocks are also provided.

Date: 2006
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